The Dangerous Education Gap

A large body of research on the behavior of individual investors has demonstrated that low levels of financial knowledge, in addition to biases in the selection and processing of information, drive suboptimal financial choices.

Among the findings from the literature are:

  • Men tend to be more financially literate than women, independent of country of residence, marital status, educational level, age, income and their possible role as decision-makers.
  • Women tend to be less confident than men, though they are more aware of their own limits. This is a positive finding, because overconfidence, which may lead to excessive risk taking, excessive trading and lack of diversification, is negatively related to performance. The result is that women outperform men. Note that it has been found that higher levels of education may lead to higher levels of overconfidence. (Any financial advisor who has worked with doctors would confirm this!)
  • Degree of financial knowledge tends to be positively correlated with education and wealth.
  • Individuals with a high degree of financial literacy tend to exhibit a higher risk tolerance and a higher degree of patience, as well as greater willingness to spend time acquiring financial knowledge.
  • Financial experience, as measured through the ownership of financial instruments and the holding period length of risky assets, is positively associated with financial knowledge.
  • Regret aversion (coupled with low literacy) may deter the demand for professional help if individuals anticipate the possibility that advisors will highlight mistakes in their previous decisions.

Monica Gentile, Nadia Linciano and Paola Soccorso contribute to the literature on investor education and behavior with their March 2016 working paper, “Financial Advice Seeking, Financial Knowledge and Overconfidence: Evidence from the Italian Market.”

The authors write: “The effectiveness of both investor education and financial advice may be challenged by individuals’ behaviours and reactions. Unbiased financial advice can substitute for financial competence only if unsophisticated investors seek the support of professional advisors. Furthermore, advice may not reach overconfident investors deciding on their own on the basis of self-assessed rather than actual capability. Conventional financial education initiatives may exacerbate overconfidence and/or other biases distorting further investors’ decision-making process.”

Drawing on data from more than 1,000 Italian households, the authors analyzed the relationship between investors’ propensity to seek professional investment advice, financial knowledge and self-confidence, as well as the determinants of financial knowledge and self-confidence.

Following is a summary of their findings:

  • The majority of individuals exhibited a very low degree of financial literacy. For example, almost half of respondents weren’t able to describe inflation, 55% incorrectly defined risk diversification, 57% did not correctly define the risk/return relationship, 72% were not able to compare investment options across expected returns and 67% showed insufficient understanding of simple interest rates.
  • Nearly 45% of investors preferred informal advice (that is, consulting relatives, friends and colleagues) to professional advice.
  • The authors, in general, found a lower level of financial knowledge among women, resulting in a gender gap.
  • Loss aversion was quite widespread. Overall, 55% of respondents weren’t willing to take financial risk, implying a chance of loss and 17% would disinvest after even a very little loss. However, financial knowledge is positively related to risk aversion. The more financial knowledge someone has, the less risk averse that investor tends to be.
  • Financial literacy positively affected financial advice seeking. The higher the level of financial literacy, the more likely it is that professional advice will be sought.
  • Financial knowledge was negatively related to high levels of investor self-confidence. Less knowledgeable investors were more confident of their skill (skill they do not, in fact, have). Overconfidence, in turn, discourages demand for advice (by the very people who need it the most).
  • Overconfidence was prevalent. For example, among individuals reporting an understanding of basic financial products equal or higher than the average person, 30% weren’t able to correctly define inflation and 44% couldn’t solve a simple-interest problem.
  • Financial advice acts as a complement rather than as a substitute of financial capabilities.

Gentile, Linciano and Soccorso concluded that their results confirm “concerns about regulation of financial advice being not enough to protect investors who need it most.”

They continue: “Additionally, our findings suggest that investor education programmes may be beneficial not only directly, i.e. by raising financial capabilities, but also indirectly, i.e. by enhancing people’s awareness of their financial capability and by hindering overconfident behaviours and behavioural biases. This latter outcome mitigates the worries about financial education fueling confidence without improving competence, thus leading to worse decisions.”

Summary

One of the great tragedies is that most Americans, having taken a biology course in high school, know more about amoebas than they do about investing. Despite its obvious importance to every individual, our education system almost totally ignores the field of finance and investments. This remains true unless you attend an undergraduate business school or pursue an MBA in finance. Without a basic understanding of finance and markets, there’s simply no way for investors to make prudent decisions.

Making matters worse is that far too many investors think they know how markets work, when the reality is quite different. As humorist Josh Billings noted: “It ain’t what a man don’t know as makes him a fool, but what he does know as ain’t so.”

The result is that individuals make investments without the basic knowledge required to understand the implications of their decisions. It’s as if they took a trip to a place they have never been with neither a road map nor directions. Lacking formal education in finance, most investors make decisions based on accepted conventional wisdom—ideas that have become so ingrained that few individuals question them.

And some spend far more time watching reality TV shows than they do investing in their own financial literacy. Given the important role that financial literacy plays in achieving financial goals, this is dangerous behavior.

 

 

This commentary originally appeared September 26 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

How Fantasy Ruins Football (and Investing)

It’s that time of year again, where the heat of summer recedes, sweatshirts make a comeback and businesses lose billions in flagging productivity due to fantasy football. But it’s not just businesses losing out—fans and players come up short as well.

How, after all, can I truly dedicate myself to rooting fully for my beloved Baltimore Ravens if I took Le’Veon Bell—who, for those not acquainted with the best rivalry in football, plays running back for the Steelers—second in the fantasy draft? It can’t be done. It’s just wrong.

I’m kidding, right?

Partly. But there are more serious personal and financial implications to embracing fantasy (sports or otherwise). The danger in fantasy is its distance from reality. It’s “betting on a future that is not likely to happen,” according to Psychology Today.

Our fantasies tend to sensationalize what we’d prefer to imagine while ignoring what we’d prefer to not. Then, when our actual spouse, child, parent, friend or co-worker falls short of the impossibly high bar we’ve set for them, we—and often, they—are crushed.

“Emotional suffering is created in the moment we don’t accept what is,” says Eckhart Tolle, who, perhaps unintentionally, delivers a potent dose of truth that especially informs us in our personal dealings with money.

Here are a handful of financial fantasies, followed by their unvarnished truths:

Fantasy: The market has made 10% per year, so I should expect to make 10% per year.

Truth: The market almost never makes 10%. In fact, in the past 88 years, only thrice has the S&P 500 ended the year with a positive return between the numbers 9 and 11! The market’s only consistent trait is its inconsistency, and while the market has actually returned an approximate annual average of 12%, you should expect to be surprised. Every. Single. Year.

Fantasy: Gold is a good hedge against inflation. (Or a good hedge against currency risk, or a good investment. Just take your pick.)

Truth: Of the many traits often attributed to gold as an investment, the only one that really holds up is that the precious metal historically has risen in price when stocks are in deep decline. People tend to buy gold when they are scared (and sell it when they aren’t). But good luck shaving off some of your bullion for bread when the Hunger Games start (or when any dystopian tween books series becomes a reality).

Fantasy: “Wow, they have a big house. They must be rich!” (That’s an actual quote from my 10-year-old son. I know. We’re working on it.)

Truth: They might be “rich.” Or they may just have a very big mortgage. Regardless, The Millionaire Next Door taught us that appearances can—and often are—deceiving.

Fantasy: Money is power. Everything would be better if I had more of it.

Truth: Literally (since 1971) and figuratively (forever), money has no value other than that which we attribute to it. Most of us have a tendency to over-value money, and in so doing, diminishing what has true power in our lives—relationships. But when we see money as the neutral tool that it is, it can be used very effectively, especially when in the service of enhancing relationships.

Fantasy isn’t all bad. Expanding our imaginations often leads to the conception—and eventually, the accomplishment—of endeavors formerly relegated to the realm of impossibility. Perhaps the key, then, is to ensure our fantasy only enhances our reality.

Fantasy football provides a great example. It can be a great way to have fun with friends, to enhance your knowledge of the game and to learn more broadly about its players. But as clutch NFL kicker Justin Tucker reminds us, “If you’re going to take it so seriously, then you’re an idiot.”

This commentary originally appeared September 3 on Forbes.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

The Influence of Recent Market Returns on the Risk Tolerance of Individual Investors (Part 2)

Last week, we examined a study that found investors’ risk tolerance fluctuates positively with recent market returns. This behavior is in direct conflict with rational economic theory, which dictates that when market returns become negative, wealth contracts and risk aversion should therefore decrease (while risk tolerance should increase).

Instead, the authors found that investment losses, combined with loss aversion, contribute to an increase in risk aversion during bear market declines. On the other hand, gains during a bull market lead to the well-documented “house money” effect and a decrease in risk aversion.

The findings from this study— Do Market Returns Influence Risk Tolerance? Evidence from Panel Data by Rui Yao and Angela Curl—suggest that individuals invest greater amounts after periods when market returns are high and withdraw partially or even completely from the market after periods when returns have been poor.

Today, we’ll examine some additional support for Yao and Curl’s conclusions, as well as explore the relationship between loss aversion and investor overconfidence.

Investor Risk Tolerance

To begin with, Yao and Curl’s findings are consistent with those of Michael Guillemette and Michael Finke, authors of the June 2014 paper, Do Large Swings in Equity Values Change Risk Tolerance?

Their study investigated whether the measured risk tolerance of U.S. and Canadian individuals correlated with market movements. Using a dataset provided by FinaMetrica, which creates and distributes a risk tolerance questionnaire widely employed by financial planners, the authors examined average monthly risk tolerance scores (MRTS) during the period from January 2007 through May 2012, a period that spans the financial crisis. A total of 341,782 people were surveyed over the time period. Their objective was to test whether fluctuations in equity returns influence average risk tolerance scores over time. The following is a summary of their findings:

  • There was a strong positive correlation (0.70) between the S&P 500 and the MRTS.
  • Risk tolerance scores are consistently lower immediately following a market decline. The correlation between the S&P 500 and the MRTS climbed to 0.90 for the period from January 2007 through March 2009, when the market bottomed out. However, the correlation during the recovery was 0. A rising market is seen by some as a buying opportunity, while others remain more risk averse after recent losses.
  • The correlation between the MRTS and consumer sentiment was 0.67.
  • When consumer sentiment was most negative, investors were the most risk-averse.
  • When consumer sentiment was the most positive, respondents were far more risk-tolerant.

Unfortunately for investors, their average monthly risk tolerance was also highly correlated with equity market valuations as measured by price-earnings (P/E) ratios. In fact, Guillemette and Finke found that risk tolerance increases when equity valuations are high (and expected returns are low), and that individuals are most risk-averse when equity valuations are low (and expected returns are high). This change in risk tolerance can lead to a buy high and sell low pattern of trading. As you would expect, this perverse behavior negatively impacts investor returns.

For example, Geoffrey Friesen and Travis Sapp, authors of the 2007 study Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability, found that individual investors lose, on average, 1.56% a year in dollar-weighted returns because they tend to pull money out of equity mutual funds following a significant market decline (when equity valuations are more favorable). Conversely, investors increase equity allocation following recent price increases (when valuations are less favorable).

As yet another example of recency’s impact, one that spanned the period of the financial crisis, the June/July 2011 issue of Morningstar Advisor looked at the behavior gap, the difference between the dollar-weighted returns earned by investors and the time-weighted returns earned by the mutual funds in which they invest, for the one-year and three-year periods ending December 2010. For domestic equity funds, the gap was 2% and 1.3% per year, respectively. For international equity funds, the gap was 0.6% and 0.8% per year, respectively.

Loss Aversion and Overconfidence

Shan Lei and Rui Yao, authors of the 2015 study Factors Related to Making Investment Mistakes in a Down Market, contribute to our understanding of investor behavior. They explored the following hypotheses:

  1. Loss aversion positively affects the likelihood of making investment mistakes.
  2. Overconfidence positively affects the likelihood of making investment mistakes.

To test their hypotheses, they used data from the 2008 FPA-Ameriprise Financial Value of Financial Planning Research Study. The data was collected online by an independent market research firm between June 27, 2008, and July 18, 2008, in the midst of the financial crisis. The total sample size was 2,792 respondents. The survey asked participants for their reaction to the market changes during the past year. One question asked: “Since the market has changed over the past year, what actions, if any, have you taken?” One possible answer was: “Moving assets into more of a cash position.”

Lei and Yao considered it a mistake if investors moved assets into cash in a down market while having an adequate amount in an emergency fund. Because more loss-averse investors are more likely to react in a down market, those who chose these items as answers were considered to be more loss-averse investors. The following is a summary of the authors’ findings, all of which are consistent with findings already discussed:

  • Consistent with the first hypothesis, respondents who were more loss-averse were also more likely to make investment mistakes.
  • Consistent with the second hypothesis, respondents who expressed more confidence were 1.4 times as likely to make investment mistakes.
  • After controlling for other variables in the model, women were found to be less likely than men to make the mistake of moving to cash during the bear market (with an odds ratio of 0.726). This is consistent with prior research that demonstrates men are more likely to be overconfident, and thus more likely to make mistakes.
  • The percentage of respondents making mistakes was generally greater for higher investable asset groups. This is consistent with the idea that investors who are more confident will be less risk-averse and hold riskier assets.

Evidence From the U.K.

Since misery loves company, it’s nice to know that U.S. investors are not alone in their bad behavior. Thanks to Andrew Clare and Nick Motson—authors of the study Do U.K. Retail Investors Buy at the Top and Sell at the Bottom? have evidence demonstrating that investors in the U.K are equally guilty of bad or irrational behavior.

Clare and Motson examined the impact of timing decisions of both retail and institutional U.K. investors. The authors’ study covered the almost 18-year period from January 1992 through November 2009. The following is a summary of their findings:

  • Just like U.S. investors (both individual and institutional), U.K. retail investors (though not institutional investors) are performance chasers as fund flows correlate with prior 12-month returns to the equity market.
  • When they examined the prior six-month returns, the correlation between market returns and fund flows increased. Unfortunately, so did the negative correlation between fund flows and future returns, and it was now statistically significant at the 99% level of confidence.
  • For retail investors, these correlations were also found to be significant between the 15- and 24-month horizons.
  • The performance gap (the difference between a buy-and-hold strategy of a fund and investor returns in that fund) for retail investors was -1.17% per year. For institutional investors there was also a performance gap, but it was smaller at -0.20%.

The bottom line is that, over the 18-year period, the performance-chasing behavior of U.K. retail investors cost them a total return loss of 20%.

The Bottom Line

Warren Buffett has warned investors that their greatest enemy is looking at them in the mirror. Three of the most common and, unfortunately, most expensive mistakes that individual investors make are: overconfidence in their ability to withstand the stress of bear markets (which may lead to panicked selling), recency, and thinking that they are playing with the “house’s” money. These three are among the 77 mistakes covered in my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them.”

But individual investors aren’t the only ones impacted by these problems. In his book, “Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing,” Hersh Shefrin reported that the risk-tolerance levels of both institutional investors and financial advisors were positively correlated with stock market returns.

Having a sound understanding of risk tolerance is not only important for individual investors, but also for their financial advisors. The research shows that while advisors may treat investor risk tolerance as a stable characteristic, it’s clearly important to periodically revisit their clients’ risk tolerance, as risk tolerance changes not only as investors age but with movement in the markets as well. If an investor’s risk tolerance does change in response to market returns, it’s likely that either the investor (or the advisor) overestimated their ability to understand risk and properly assess their individual risk tolerance. And thus a change in the overall financial plan may be required.

This commentary originally appeared May 3 on MutualFunds.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

The Influence of Recent Market Returns on the Risk Tolerance of Individual Investors

 

The recency effect—that the most recent observations have the largest impact on an individual’s memory and, consequently, on perception—is a well-documented cognitive bias. This bias could impact investment behavior if individuals focus only on the most recent returns and project them into the future. Such behavior may lead investors to experience a reduction in their risk tolerance (which, in turn, can lead to selling) after a bear market, when valuations are lower and expected returns are higher. Conversely, recency may lead investors to experience an increase in their risk tolerance (which, in turn, can lead to buying) after a bull market, when valuations are now higher and expected returns are lower.

The Recency Effect

The recency effect nudges investor behavior in a direction contradictory to economic theory, which states that relative risk aversion is a function of increasing wealth (the marginal utility of wealth declines as wealth increases). Strong market returns would increase investor wealth, and thus we should see a reduction in investor risk tolerance.

Rui Yao and Angela Curl—authors of a 2011 study, Do Market Returns Influence Risk Tolerance? Evidence from Panel Data, which appeared in the Journal of Family and Economic Issues—hypothesized that the recency effect would dominate rational economic behavior. They posited that risk aversion is negatively related to recent market returns (or, in other words, that risk tolerance is positively related to recent market returns).

Their study used data from the 1992, 1998, 2000, 2002 and 2006 interview waves of the Health and Retirement Study (HRS), an ongoing biannual study conducted by the University of Michigan and funded through the National Institute of Aging. The target population for the HRS is noninstitutionalized men and women, born from 1931 to 1941, living in the contiguous United States. Based on responses to a set of income gamble questions, researchers assigned participants to a risk tolerance level for each wave: most risk tolerant, second-most risk tolerant, third-most risk tolerant and least risk tolerant. Stock market performance was measured as a continuous variable using the S&P 500 Index’s trailing 12-month returns prior to each interview. The following is a summary of the authors’ findings:

  • Consistent with the recency theory and their hypothesis, there was a significant positive linear relationship between S&P 500 returns and respondent risk tolerance.
  • Controlling for time and other independent variables, a one percentage point increase in market returns increased the probability of taking substantial or high risk by 1%. A one-standard-deviation increase in S&P 500 returns increased the likelihood of taking substantial or high risk by 15.7%.
  • When the stock market is falling, average monthly investor risk tolerance scores are strongly correlated with changes in the S&P 500. However, when stock prices start to rise, changes in average risk tolerance seem to be largely uncorrelated with the market.

Yao and Curl also found that:

  • Each additional year of age above the sample mean decreased the likelihood of taking some risks by 2%—consistent with theory and prior research showing that the likelihood of being in the high-risk or some-risk groups decreases as people age.
  • Higher educational attainment was consistently predictive of higher levels of risk tolerance.
  • Investors with greater financial assets reported lower levels of risk tolerance. This is consistent with the theory of declining marginal utility of wealth.

The key finding is in direct conflict with rational economic theory. When market return becomes negative, wealth decreases. Therefore, risk aversion should decrease (and risk tolerance should increase). But Yao and Curl’s analysis found that risk tolerance fluctuated positively with market returns. While the loss of money, combined with loss aversion, contributes to an increase in risk aversion during a bear market decline, gains during a bull market lead to the well-documented “house money” effect and a decrease in risk aversion.

The authors concluded that investors don’t behave according to rational economic model assumptions, and that “such changes in risk tolerance in response to market returns may be an indication that investors, and possibly their financial advisors, overestimate their ability to understand risk and assess individual risk tolerance.”

These findings suggest that individuals invest more after periods when market returns are high and withdraw partially or even completely from the market after periods when returns have been poor. Yao and Curl reached the conclusion that their findings support “the projection bias hypothesis and confirms the recency effect.” What’s more, their findings on investor behavior are consistent with those from the field of behavioral finance.

Behavioral Finance

For example, Richard Thaler and Eric Johnson, authors of the 1990 study Gambling with House Money and Trying to Break Even: The Effect of Prior Outcomes on Risky Choice, found that individuals experience less dissatisfaction from losses after a prior gain and greater dissatisfaction after a prior loss. Thus, risk aversion is time-varying and dependent on prior outcomes.

Yao and Curl’s findings are also consistent with those of Robin Greenwood and Andrei Shleifer, authors of a 2014 study, Expectations of Returns and Expected Returns. They were able to document a strong negative correlation between investor expectations of stock returns and recent returns for the S&P 500—investors change their expectations of the reward from taking risk based on recent changes in stock market returns.

The financial crisis of 2008 provided a good example of how recency impacts investor risk tolerance. During the crisis, individual investors pulled out hundreds of billions of dollars from the equity market. The result was that, by 2010, portfolio allocations to risky assets had declined to their lowest level for people under the age of 35 in the history of the Survey of Consumer Finances.

A more recent example can be found by examining the returns from emerging markets and investor flows. From September 2014 through September 2015, the MSCI Emerging Market Index lost more than 23%.Investment Company Institute data shows that beginning in July 2015, emerging-market funds experienced net withdrawals in every single month. For the period from July 2015 through January 2016, total net withdrawals exceeded $13 billion.

Next week, we’ll examine some additional support in the research for Yao and Curl’s findings, as well as explore the relationship between the recency effect and loss aversion and investor overconfidence.

 

This commentary originally appeared April 26 on MutualFunds.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE